Explaining the Types of Inflation

Inflation happens when prices rise across the economy. Goods and services such as food, gas, rent, and clothing are usually where people feel inflation the most.

But prices can change for different reasons, in different ways, and at different speeds. Prices may change because a good or service is in higher demand or there have been significant impacts to supply. Larger shocks to the economy such as stock market crashes, pandemics, or war can also impact pricing.

Each instance of inflation is different. However, the general principle can be understood by looking at three key characteristics of inflationary forces: the pace, the cause, and how it is measured.

Inflation by Pace

The speed of inflation can vary a lot. In some cases, prices increase by a manageable 2% a year, encouraging individuals to invest their money to maintain its value. In other cases, inflation can happen catastrophically fast, or even go into reverse.

Creeping Inflation

Creeping, or mild, inflation occurs when prices rise slowly. According to the Federal Reserve, when prices increase by 2% or less, it benefits economic growth. This kind of mild inflation makes consumers expect that prices will keep going up, which boosts demand. Consumers buy now in order to beat higher future prices, and so mild inflation drives economic expansion. For that reason, the Fed sets 2% as its target inflation rate.

Walking Inflation

This type of inflation is faster than creeping inflation, but not as fast as galloping or hyperinflation. It is harmful to the economy because it heats up economic growth too quickly. People start to buy more than they need in order to avoid tomorrow's much higher prices. This increased buying drives demand even further, and suppliers often can't keep up. More importantly, neither can most people’s wages. As a result, you can be priced out of common goods and services.

Galloping Inflation

When inflation rises to 10% or more, it can be very damaging to the economy. Money loses value so quickly that business and employee income can't keep up with costs and prices. Foreign investors, in turn, avoid the country where this occurs, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. For this reason, avoiding galloping inflation is a key objective of many central banks.

Hyperinflation

Hyperinflation occurs when prices skyrocket by more than 50% per month. It is very rare. In fact, most examples of hyperinflation occur when governments print money to pay for wars. One of the most extreme examples is Hungary, where in 1945, prices doubled every 15 hours. Venezuela has been fighting a bout of hyperinflation since the early 2010s.

Deflation

Inflation can also go into reverse; this is a situation in which prices are decreasing. This can happen, for instance, when an asset bubble bursts. This is known as deflation. Once deflation starts, it is harder to stop than inflation. It can be damaging to an economy because people will put off purchases because they are waiting for lower prices.

That's what happened to the housing market in 2006. Deflation in housing prices meant many people who had bought their homes a few years before the decline found their house was now worth less than the value of their mortgage. In fact, the Fed was worried about overall deflation during the recession. That's because deflation can turn a recession into a depression. At the height of the Great Depression, prices dropped by more than 10% in one year.

Inflation by Cause

Inflation can be caused by a wide variety of factors. If a government prints a lot of money to pay its debts, as happened in Germany in the 1930s, this can lead to a widespread decrease in the value of money, leading to inflation. In other instances, the causes of inflation are not as well defined.

Demand-Pull and Cost-Push

In economics, it’s possible to distinguish between two types of inflation: demand-pull inflation and cost-push inflation.

Demand-pull inflation occurs when the need for goods and services is higher than the available capacity required to meet it. This would make the in-demand product or service more expensive.

Cost-push inflation occurs when it becomes more expensive to produce goods or provide services. This can be caused by rapidly increasing wages or material costs.

Wage Inflation

In other cases, a rise in wages might cause prices to rise across an economy. In this case, companies have to pay their workers more, and they often pass on the increases to the consumer, which causes inflation in the price of goods and services.

Wage inflation occurs when workers' pay rises more rapidly than the cost of living. It can happen when there is a shortage of workers, or in other situations where wages are driven up quickly.

Stagflation

Stagflation occurs when economic growth is stagnant but prices continue to rise. 

This combination seems contradictory, but it happened in the 1970s when the United States abandoned the gold standard. Once the dollar's value was no longer tied to gold, it plummeted. At the same time, the price of gold skyrocketed. Stagflation didn't end until Federal Reserve Chairman Paul Volcker raised the fed funds rate to double digits. He kept it there long enough to dispel expectations of further inflation.

Measures of Inflation

Just as inflation can happen at different paces and have different causes, it can also be measured in a variety of ways.

Core Inflation

The core inflation rate measures rising prices in everything except food and energy. That's because food and gas prices tend to be very volatile, and including them in inflation measures can give an inaccurate impression of how prices are fluctuating within an economy.

The Federal Reserve uses the core inflation rate to guide it in setting monetary policy. The Fed doesn't want to adjust interest rates without significant evidence that everything is becoming more expensive.

Asset Inflation

Asset inflation also refers to rising prices, but in a more limited way. Instead of prices rising across a wide range of goods, asset inflation refers to the price of a particular asset increasing. Examples of assets that can be subject to inflation are housing, oil, and gold.

Shrinkflation

A more unofficial measure of inflation is shrinkflation. Shrinkflation refers to the reduction of a package’s contents as a result of high inflation.

Manufacturers provide less of a product in each package instead of raising the price. That means you pay more in the long run because you’re getting less of the product, while manufacturers save money on supply costs.

To tell if a product you are looking to buy is experiencing shrinkflation, compare the price and size over time.

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